If I had to sum up this book in one word, I'd choose "gem." Any individual aiming to profit from the market must read this book meticulously, line by line.
Speculator must have a carefully crafted plan for trading the markets--one that has been created to fit the trader's unique personality and level of risk tolerance.
(page 2)
Your personality and trading plan are two factors you cannot disregard in your speculation.
We do not believe that specific prices in the future can be accurately forecast, nor do we believe that specific turning points can be forecast by any method. We do believe that substantial profits can be made by promptly recognizing trends in progress and by quickly taking advantage of turning points as they occur. Our technical analysis has been devoted to methods of finding and measuring the strength of trends, then closely monitoring those trends to observe, as quickly as possible, when the trend might be changing.
(page 4)
Attempting to predict the market is futile. However, forecasting market trend strength or focusing on potential directions is where traders can channel their efforts. A well-rounded trading system comprises timing theories/forecasting methods, risk control, and money management.
One of the disadvantages of computer power is that it allows such a thorough analysis of past data that almost any number of repetitive patterns and observations can be found. The computer gives us the capability to do such an exhaustive analysis over any set of numbers that we now find patterns, cycles, waves, and other supposedly recurring relationships not only in future prices but in sets of random numbers.
(page 4)
I agree with the argument presented in this passage. The logic behind any trading system is of paramount importance. Only rules supported by clear and coherent logic have the potential to be replicated in future trends. Overfitting is a significant adversary in the development of trading systems. In effective theories, simplicity is often the best approach.
Are the market we follow trending up, down, or sideways? (Yes, we consider sideways to be a trend direction).
(page 13)
Sideways movement itself is a trend direction. This notion is quite novel and is indeed worth exploring in practical trading scenarios.
As you can see, there is only up or down, and no possibility of identifying a sideways market when using only one or two moving averages. However, it is possible to construct a sideways reading if we use more than two moving averages. For example, using 4/9/18 moving averages: if the 9 is above the 18 but the 4 has gone below the 9, we could conclude that the market was sideways.
(page 13)
Single or dual moving average systems are incapable of identifying sideways trends. They can only provide two possibilities: up or down. However, a triple moving average system can offer insights into sideways trends. From my perspective, sideways trends occur when short-term trends fail to develop into long-term trends.
For now, let us assume that we are using two trend indicators and, when they agree on a direction, then there is a trend in that direction. When they fail to agree, we will say that the trend direction is sideways. We do not recommend reversal strategies, which fail to identify sideways markets and are always in the market going from long to short and vice versa. These reversal systems tend to be continuously whipsawed in sideways markets and have no hope of success unless the markets trend for sustained period.
(page 15)
It has been our observation that traders spend entirely too much money and effort searching for methods of timing entries into the markets. Somehow, a very mistaken belief has developed, that success depends on entry timing and that, if the entry is done precisely, everything else will follow. As far as futures traders are concerned, the search for the perfect entry system has become much like the search for the Holy Grail. Unfortunately, the truth is that the entry is probably one of the least important ingredients in a complete and well-designed trading system. We assert that the real key to profits is knowing how to exit.
(page 20)
The amount of losses is the only parameter you can control in your trading.
One of the best profit-taking strategies we know is a compromise that offers the advantages of taking quick profits while still allowing the potential for big profits. You simply operate a two-unit trading account and take the profit on one position at a conservative targeted price and let the second position run in hopes of catching a big winner.
Another simple but very effective method is to just use a trailing stop at all times and stay in the trade until the stop is hit. Using this method you will be aware of exactly how much profit you are likely to give back at any time. As simple as this exit method might seem, it stands up well under historical testing, and it is difficult to find a better exit. The trailing stop can be combined with the overbought/oversold method (using RSI) described previously to provide the opportunity to exit closer to the top now and then.
(page 23)
How good is your present exit strategy? A good way to test your exit proficiency is to enter a series of hypothetical trades at random, with no concern for direction or timing. Then place your exit stops and implement your profit-taking strategy. After running through 30 or more of these hypothetical trades, if your results (in terms of gross profits) are not better than break-even, your exits need to be improved.
(page 24)
These points are strongly advised for formulating a sound exit strategy.
The vast majority of profitable trading systems incorporate some form of trend following, yet most of the time the markets are not trending strongly enough to generate worthwhile profits. Because successful traders employ a policy of taking small losses and letting profit run, the non trending markets seems to move only far enough to produce the small losses.
(page 35)
Trend trading, counter-trend trading, and breakout trading are the three primary trading approaches. Among these, trend trading is the most counterintuitive yet the most profitable. Counter-trend trading is the most intuitive but also carries the highest risk.
The directional movement indicator (DMI) is a useful and versatile technical study that has two significant functions. First the DMI itself is an excellent indicator of market direction. Second one of the DMI's derivatives is the important average directional movement index (ADX), which not only allows us to identify markets with trends but also gives us a means to quantify the strength of the trends.
(page 35)
At the first glance it might seems that Colby and Meyers were following the trend by trading only when the ADX was rising. However, since they implemented trades based on the +DI and -DI crossover after the ADX was rising, the system is more of a counter-trend method, because the rising ADX was the result of the trend in existence prior to the current crossover. When the +DI and -DI cross after the ADX is rising, it would signal a trade in the opposite direction from the trend being measured by the rising ADX.
(page 40)
Bollinger bands are normally used with other technical studies to detect trend reversals in the stock market. If prices are close to the lower band and another study confirms the reversal, it should be safe to buy. For example, an RSI divergence might be used to confirm a bottom in the lower portion of the envelope.
(page 53)
In addition to envelopes that are defined by distance from a moving average, there are channels defined by high and low points over a specified time period. The simplest of these channel methods is a pure reversal system, which is always in the market. An upper band is formed by the high of the past 10 days, for example. A lower band is formed by the low of the same number of days, with the two bands forming a channel. The channel will change in width as old highs or lows are dropped and as new highs or lows are made. The system is long when the highest price is penetrated, and it stays long until the lowest price is penetrated. Since this is a reversal system, when the long is closed out a short position is assumed.
(page 57)
Our research has shown us that, in a general sense, the CCI is a tool, much like ADX, that can help give a valuable measurement of the overall trendiness of a market. As we pointed our earlier, the faster the CCI is accelerating, the more strongly the market is trending. While it is perhaps mathematically possible for the CCI to move upward while the market does not, this is unlikely to happen. Keep in mind that the CCI can provide important information to a trader even when it is not giving entry signals. If a market stays inside the +/- 100 most of the time, it is demonstrating the absence of a trend, so avoid that market or use a countertrend trading strategy.
(page 67)
We also observed that our often recommended technique of waiting for confirmation after a trading signal is an excellent method of eliminating most of the whipsaws with the faster CCI periods.
(page 67)
Entering a trade at the open of the bar immediately following the signal bar can often lead to being trapped, especially in intraday ultra-short-term scenarios. This is largely due to the sensitivity of indicators used in intraday ultra-short strategies, as their parameters tend to be small. Sometimes, a single tick's breakout can extend into the subsequent bar, but it might not persist over the following bars. In such cases, entering the market based on this signal could frequently result in minimizing losses rather than maximizing gains. Hence, the optimal approach is to wait for several bars, allowing the market to confirm its direction, before entering. This principle holds true for exits as well.
Divergence are particularly dangerous signals, because you are normally trying to pick a top or bottom of some sort. The most important thing to remember about trading divergences is to wait until the divergence is confirmed by a close or series of closes in the direction of the new trend. Do not anticipate.
(page 71)
The multiple trades in April validated this statement. Divergence might indicate an impending change in trend, but it doesn't necessarily provide entry and exit points. It's essential to wait until the market confirms its direction before opening a position.
Since lengthening the momentum period will make the oscillator less responsive, and shortening it can cause whipsaws, some traders have found it helpful to use a relatively short and highly responsive momentum value and then put boundaries above and below the zero line. Then they use a crossing of the boundary lines, instead of the zero line, to signal new trades. When the momentum oscillates within the boundaries, it doesn't signal new trades. This has the effect of making the market prove itself before entering a position and eliminates many whipsaws generated by frequent crosses of the zero line.
(page 80)
Incorporating a buffer zone between long and short positions is a common approach to enhancing indicators. Prior to the inclusion of this buffer zone, the indicator serves as a reversal indicator (with funds allocated within the market at all times). Following the addition of the buffer zone, funds will spend a certain amount of time outside the market.
Because momentum measures the acceleration or decelleration of a market, it becomes very useful as an overbought/oversold indicator. When the market reaches a top, momentum will level off or begin to decline, often well before the actual market peak. A similar divergence in directions will occur at a market bottom. Assuming no major changes in market volatility, lines drawn on a long-term chart connecting momentum tops and bottoms will be parallel to and on either side of the zero line and will represent overbought/oversold zones. The basic trading strategy here is to sell just when the upper zone is penetrated, placing a protective stop above recent highs, and to buy just when the lower zone is penetrated, placing a stop below recent lows. Profits can be taken when the opposite zone is reached. This is a countertrend strategy.
(page 81-82)
Some applications of "oversold" and "overbought" are employed in counter-trend trading strategies. It's important to distinguish this usage.
One of the most productive uses of momentum is to define a long-term trend and, once the trend is defined, trades should be taken only in that direction. A logical combination of technical studies here would be to use the long-term momentum to find the trend, use the intermediate-term moving averages to enter trades while the momentum is strong, and then use a shorter-term countertrend indicator, such as stochastics or RIS, for profit taking when the momentum weaken.
(page 83)
Combining the momentum indicator with certain trend filters can enhance its effectiveness. Different indicators can serve as potent entry and exit signals, producing notable results.
Many of the technical studies we mention in this book measure, in one way or another, the strength of a market. This is normally revealed by the slop of the line created by the study's calculation. For example, a steeply trending moving average usually means that the underlying market is trending strongly. The steeper the slope, the stronger the trend. Determining the exact degree of steepness can be very subjective, if we only look at the technical study; but if we calculate a momentum or rate of change of the indicator, we can very objectively quantify the degree of slope. This opens up all sorts of possibilities. We can filter out weakly trending markets and concentrate our trend-following efforts on markets with unusually strong trends. Or if a market is not trending, we can buy dips and sell rallies. We believe that momentum has many worthwhile applications and ranks as one of the most useful studies available to the futures trader. An imaginative and resourceful technician should find many interesting uses for this indicator, which leads prices instead of following them.
(page 84)
Futures trading is more art than science, and mathematical accuracy does not insure profitability. (page 89)
We believe that exits should always be quicker than entries in a successful trading system. Entries should be slow and selective, perhaps requiring an uncommon event to provoke a trade. Exits should be slow enough to patiently allow profits to run, yet quick enough to eventually capture the major portion of the potential gain.
(page 93)
Rather than blindly following all crossovers, many traders use a variety of filters to decide if the initial signal is valid. Filters come in two categories: price filters and time filters.
1). Filtering signals by price normally means waiting for the price to meet some additional criteria before entering the trade. The trader in this instance is looking for confirmation that the moving average crossing was not a random price event but is indeed a trend change.
2). Time filters involve waiting a number of time periods after the crossover before trading in the new direction.
(page 98)
Stochastics work best in broad trading ranges, or in a mild trend with a slight upward or downward bias. The worst market for normal use of stochastics is a persistent trending market that has only minor corrections...We think the primary value of stochastics is as an indicator of bottoms and tops.
(page 133)